6 Valuation-Based Contrarian Picks

Today, independent thinkers are also confronted with the challenge of identifying the consensus. Who isn't a contrarian or a value investor today? How can a consensus be identified when everyone claims to be different?

Challenging the consensus has always been difficult. Contrarians have to ignore the allure of popular stocks, interviews in the financial media, and other distractions in order to focus on valuation.

Even though Jim Cramer's trades are not long-term recommendations, his picks can be a very useful barometer of investor and media attitudes. Contrarians can use his picks as an indicator of current market sentiment to selectively counter.

Of Cramer's 75 buy and sell stock opinions recently issued on CNBC's Mad Money (12.17.2012 to 12.21.2012), three buy calls and three sell calls can be challenged on a valuation basis. Dunkin' Brands Group (NASDAQ:DNKN), Urban Outfitters (NASDAQ:URBN), and Weyerhaeuser (NYSE:WY) are too richly valued to be buy picks. On the other hand, Tronox (NYSE:TROX), Cliffs Natural Resources (NYSE:CLF), and Northern Tier Energy (NYSE:NTI) are too cheaply valued to be sell picks.

These picks are summarized below:

Ticker

Cramer's Call

Airdate

P/E

P/B

P/S

DNKN

Buy

12/21/2012

45.6

10.91

5.21

TROX

Sell

12/20/2012

1.24

0.77

1.26

CLF

Sell

12/19/2012

5.53

0.8

0.84

URBN

Buy

12/19/2012

29.64

4.53

2.16

NTI

Sell

12/17/2012

5.9

4.47

0.53

WY

Buy

12/17/2012

49.37

3.51

2.28

Click to enlarge

After reviewing the price multiples of DNKN, URBN, and WY, it is clear that these stocks are richly valued according to static valuation metrics. Each of these stocks has a high price-to-earnings ratio and either a high price-to-book ratio or a high price-to-sales ratio.

Sadly, even pleasant future growth scenarios are not much consolation for such richly valued stocks. What could an investor expect from these picks?

Total returns were calculated over a three year holding period for each of these stocks. (I use a 3-year holding period since above-average growth estimates are not reliable further out.) Giving these buy recommendations the benefit of the doubt, each stock is assumed to be sold at a generous growth stock price-to-earnings multiple of 17 and the maximum of historical and analyst estimate values for earnings growth are assumed. These assumptions are used to project an annualized total return over the next three years and a terminal price to earnings ratios, that is, price paid today divided by earnings at the end of the holding period for each stock:

3 Years Great Growth

Ticker

Cramer's Call

g (past)

g (future)

Terminal P/E

Annualized Return

DNKN

Buy

NA

17.0%

45.6

-39.3%

URBN

Buy

11.5%

17.0%

21.4

-22.4%

WY

Buy

-15.2%

5.3%

81.0

-49.8%

Click to enlarge

Even after incorporating optimistic earnings growth, these stocks are just too expensive.

Alternatively, TROX, CLF, and NTI were discovered as contrarian buy picks with attractive valuations by sifting through the week's sell recommendations. These contrarian buy candidates were evaluated using conservative assumptions. A bargain value stock price-to-earnings multiple of 10 and the lesser of historical and analyst estimates values for earnings growth are assumed. These assumptions are used to project an annualized total return over the next three years and a terminal price to earnings ratio, that is, price paid today divided by earnings at the end of the holding period for these stocks:

3 Years Poor Growth

Ticker

Cramer's Call

g (past)

g (future)

Terminal P/E

Annualized Return

TROX

Sell

146.8%

NA

1.2

103.9%

CLF

Sell

34.9%

0.6%

5.4

25.4%

NTI

Sell

NA

10.0%

5.9

31.4%

Click to enlarge

The attractive valuations of these stocks protect cushion from tough scenarios, providing them with better odds for positive returns.

These projected returns ignore popularity while using valuation and near-term growth to calculate the consequences of buying expensive and cheap stocks. Instead of picking stocks based on current popularity, the calculation of expected returns converts growth projections and a reversion from current extreme valuations into 3-year return estimates. They flip the script on these six stock calls.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.